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Sunday, March 23, 2014

Foreign Tax Credits for Individuals—The Sequel


We’ve discussed similarities and differences in taxation between U.S. citizens working in the U.S. and U.S. citizens working abroad. Our facts for that discussion which we will build upon in this article are:

  1. Cindy is a U.S. citizen who lives and works in the U.S. She earns $100,000. At an assumed effective tax rate of 20%, her U.S. tax liability is $20,000.
  2. Justin is a U.S. citizen who lives and works in Italy. He also earns $100,000. Because Justin is a U.S. citizen, he is subject to U.S. tax on his worldwide income at an assumed 20% rate. Italy will also tax this income at a rate of 15%. Justin may, however, offset his U.S. income tax with a foreign tax credit (“FTC”). In other words, his $20,000 U.S. tax liability may be offset by a credit for Italian taxes paid of $15,000, resulting in a net U.S. tax liability of $5,000. Justin’s effective (worldwide) tax rate is 20%.

Justin and Cindy had the same effective tax rate on their income even though Justin’s tax dollars were paid to two countries and everything seemed fair.

Let’s assume that Justin wasn’t happy paying an additional $5,000 to the U.S. on his income. He tells his Armanino tax professional the following:

“It still doesn’t seem fair that I have to pay U.S. tax, too. Living in Italy my employer withheld $18,000 from my paycheck for taxes. In addition, I know I had to pay VAT tax (like a sales tax) of more than $2,000 when I bought my car here, and my friend was short on cash, so I paid $3,000 of his Italian taxes. Seems to me that since I paid $23,000 in tax in Italy, that amount should more than cover my $20,000 U.S. tax liability with those FTCs, right?”

Unfortunately, we have to give Justin the bad news that, just because a payment made abroad is called a “tax,” it may not qualify as a FTC and offset U.S. income tax.

To qualify as a FTC the tax must be an income-type tax. Countries have a way of creating new taxes that look something like an income tax and something like an excise tax. In those cases, we have to dig down into the definition of “income tax.” In this case, it is clear that a tax on a purchase of an item (i.e. VAT) is not an income tax and won’t be allowed as a FTC.

The foreign tax must be a tax imposed on the taxpayer. So even though paying his friend’s tax is a nice thing to do, since it’s not Justin’s tax, it can’t be used as a FTC.

What about the withholding amount? Well, this is a bit more interesting. The withholding tax was a tax on Justin, but is it really a tax imposed on Justin? If Justin files an annual tax report in Italy and his effective tax rate is only 15%, the true tax imposed on Justin is only $15,000, and not the $18,000 that was withheld. And, Justin will receive a $3,000 refund, lowering the available FTC to $15,000. But, what if Justin chooses not to file a tax return in Italy since Italy already has more than enough tax on his income? Just because Justin decides not to request the refund, does not mean that he would receive an FTC of $18,000. The credit remains at $15,000 (i.e.Italian tax imposed on him).

In our next article, Justin travels to Germany where the effective tax rate is 45%. Justin will pay $45,000 in tax on his $100,000 salary to Germany, will pay $0 tax in the U.S. via the use of a $20,000 FTC, and have excess FTC of $25,000. Justin is not happy since his effective tax rate jumped from 20% to 45%, so he called his Armanino tax professional to see what he can do to further lower his taxes.

Stay tuned.

Tax Reform Update: International Tax

  • A significant amount of dividends (95%) paid by controlled foreign corporations to its 10% U.S. shareholders would be exempt from tax.
  • The indirect foreign tax credit system would be repealed.
  • A new category of foreign income currently taxable in the US would be formed called “foreign base company intangible income.”

The benefits related to offshore captive insurance companies would be decreased.

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